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Clients often ask us to help them value their business, and are surprised when we ask them for what purpose they require the valuation. The way we value a business depends upon the use to which the valuation will be put:
Each purpose requires a different approach to valuation - and each approach produces a different value.
Suppose you are thinking of selling or buying a business. When it comes down to it, a business is worth what someone is willing to pay for it. Even so, it helps to have some guidelines to make the valuation as 'objective' as possible. Although different valuations follow different rules, over the years certain preferred valuation methods have evolved. These fall broadly into two categories - the earnings approach and the net assets approach.
The earnings approach starts from the profits, and effectively follows the way you would evaluate any type of investment. Basically an expected rate of return is applied to the earnings of the business to arrive at a corresponding capital value.
For example, suppose you would require a 20% rate of return for the risk of investing in a particular business. If its annual profits were £50,000, a simple earnings approach would value this business at £50,000 divided by 20% = £250,000.
Alternatively, if another business with similar profits were to be seen as a less risky investment, or as having better prospects of growth, it might be valued at £500,000, a rate of return of only 10%.
In some circumstances it is more appropriate to concentrate on the balance sheet of the business, adding up the fair market values of the assets used in the business and deducting the known liabilities. This approach would be particularly relevant to a business such as a property-holding company. The drawback is that it completely ignores the profitability of the business.
Goodwill can be quite an abstract concept, but in essence it represents a premium that someone is willing to pay over a strict net asset valuation. In some ways it reflects the advantage of being able to earn full profits straight away rather than building up an equivalent new business from scratch. It may also accrue from a motive of eliminating competition.
Factors such as brands and other 'intellectual property' present a special challenge, and require expert treatment. Other factors to consider are reputation, customer profile, and, by no means least, the experience and skills of the employees.
Published price-earning (P/E) ratios are sometimes used as a starting point. These ratios are based on profits after deducting tax at the full corporation tax rate. Formulas used for smaller businesses often start with earnings before interest and taxes, with adjustments for items such as owners' salaries and benefits, and any excessive expenses.
Most traditional methods rely on analysing average historical earnings. Often the average figure used is weighted in favour of the more recent results. However, it is said that the past is no guide to the future, and there is some merit in forecasting earnings into the future and then discounting them at current interest rates. Although this approach is academically sound, projected future earnings are only estimates and may or may not come true. So discounted cash flow has to be treated with a measure of caution.
As you can see, valuing a business is a complex process, and good, professional advice is essential. We are always happy to advise and assist with this matter. Please contact our office if you would like further information.
|A worked example|
|The following figures have been extracted from the accounts of the white business:|
|Debtors and Cash||50,000|
|Total Net Assets (book value)||205,000|
|Profit before tax||35,000|
Suppose Mr Green wishes to buy this business because it would complement his own, and is also in a very good location. From examining the accounts and making other enquiries, he concludes that the following adjustments should be made when considering the figures:
The adjusted figures are then as follows:
|Debtors and cash||50,000|
|Total net assets (book value)||170,000|
|Profit before interest and tax||40,000|
Mr Green believes that this level of profit is realistic and will be sustainable. His expected rate of return is 20%, and he is therefore prepared to offer £200,000 for the business. This represents a goodwill element of £30,000 on the revalued net assets of the business.